Volatility, Flash Events in Oil Markets: Kemp

Crude oil prices have been more volatile this year than at any time since the financial crisis of 2008/09 and before that 1991, according to standard measures of price variability.

Some of the increase in volatility is more apparent than real, however, as every $1 per barrel move translates into a larger shift in percentage terms now that prices have halved from $100 per barrel to less than $50.

The chief of the U.S. Commodity Futures Trading Commission (CFTC) warned a conference last week the oil market had already experienced 35 "flash events" since the start of the year.

CFTC Chairman Timothy Massad defined flash events as occasions on which prices moved by at least 200 basis points within an hour but returned to within 75 basis points of the starting position within the same hour ("Evolving structure of the U.S. Treasury market" Oct. 21).

The definition, which Massad acknowledged was "somewhat arbitrary", was derived from the significant round-trip move in the price of U.S. Treasury notes and bonds in October 2014.

The large move and retracement in Treasury prices between 0933 ET and 0945 ET on Oct. 15, 2014, had only been exceeded on three times since 1998 ("Joint Staff Report on the U.S. Treasury Market," July 2015).

On previous occasions, big moves in bond prices coincided with significant policy announcements, but this time there was no obvious cause for the surge in volatility and deterioration in liquidity.

Sudden and unexplained flash crashes have been observed in other markets including the U.S. stock market (May 6, 2010) and crude oil (May 5, 2011 and Sept. 17, 2012).

Flash events can occur on any scale from seconds and minutes to hours, days or even weeks with many of the same forces at work.

Flash crashes are simply a very compressed version of the wider phenomenon of financial market bubbles and crashes which includes the stock market crashes of 1929, 1987 and 2007.

But the definition must be handled with care and should be adjusted to scale with the different levels of volatility ordinarily present in different asset markets.

COMPLEX SYSTEMS
The possibility of extreme events in complex systems has been extensively explored by researchers in fields as diverse as behavioural economics, finance, electrical engineering, chaos theory and population biology.

Perhaps the best treatment of extreme events in financial markets is Didier Sornette's book on "Why stock markets crash: critical events in complex financial systems" published in 2003.

Flash crashes in financial markets share many similarities with the cascading blackouts that periodically cause electricity grids to collapse, most famously in the United States and Canada in August 2003.

Contacts between a handful of power lines and overgrown trees one afternoon in Ohio led to a chain of events that cut power to 60 million people across the United States and Ontario in less than five minutes.

In complex systems characterised by non-linear relationships and positive feedback, small changes to the initial condition of the system can result in very large shifts in outcomes.

The idea that small causes can produce large effects offends the human mind's sense of orderliness (which wants cause and effect to be roughly proportional) but is actually quite common.

It helps explain why commodities and other financial markets exhibit far more very large price movements than would be expected if price moves followed a Gaussian or normal distribution.

The non-normal behaviour of commodity prices was identified by Benoit Mandelbrot in the 1960s following a study of more than 100 years of cotton markets ("The variation of certain speculative prices" 1963).

DEFINITION STRETCH
The CFTC was correct to identify the events of Oct. 15, 2014 in the U.S. Treasury market as a "flash event" and to note that other markets have experienced flash crashes.

But it was wrong to stretch the flash event label to cover 35 events in the U.S. crude oil futures market since the start of 2015.

Applying a threshold for identifying flash events from one market (Treasury bonds) to another market (WTI) fails to account for the important differences between them.

Commodity prices are much more volatile than bonds. Price moves that are highly unusual in the U.S. Treasury bond market are actually commonplace in oil and other commodities.

The standard deviation of daily price moves in the oil futures market for WTI has been around 2.4 percent since 1990. Very large price moves have been surprisingly frequent over the last 25 years.

By applying a definition of "flash event" derived from U.S. Treasuries to the oil market, the CFTC hugely overstated the number of true flash events in the oil market.

The CFTC defined volatility in terms of a percentage move in WTI prices, which is the common method of measuring volatility in financial and commodity markets.

But since the price of WTI has halved since the middle of 2014, a 200 basis point move is less than $1 per barrel, a fairly normal intra-day move in prices.

Trading ranges of $1, often reversed, are just part of the normal ebb and flow of the oil futures market.

Traders are well aware of the regular occurrence of volatility at all timescales since it is part of their everyday life and what makes trading so challenging.

It is misleading to label these normal trading conditions as flash events and draw conclusions about market functioning.

By John Kemp